Ignorance leads to opportunity – at least that’s the theory of one London-based fund manager, who has singled out the biotechnology sector as offering some of the best growth stocks on his Australian watch list.

The fundie, who declined to be named, said the potential advantage comes about because the Australian investor “just doesn’t get it". It’s a harsh but fairly true assessment, say analysts who cover the beat.

But it’s not just mum-and-dad investors. Company executives often complain that local fund managers and analysts don’t have a strong understanding of the sector either.

So if even the professionals can stumble, what hope is there for retail investors to identify and profit from the next wonder drug? Morgans analyst
Scott Power
says the place to start – Biotechnology 101, if you will – is taking a broader look at emerging life ­science companies.

Outside of the standard definition of biotech (drug developers), there are companies in five other categories that have lower technical risk, Power says. He points to medical devices, drug delivery, diagnostics, e-health and service providers. “Drug discovery is the most difficult to pick," he adds.

The reason it’s tough is because the route from innovative science to blockbuster drug involves companies clearing a series of expensive hurdles before they make a sale. This includes three stages of clinical trials and then regulatory approval in different markets – with the United States usually the main goal. Before each yes/no moment, stocks can rally and then get jostled around if the outcome is not positive.

A recent ­example is
Prana Biotechnology
, which this week fell 74 per cent in a day after its drug failed to show any benefits in patients with Alzheimer’s disease.

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Power has a few key picks in each of his mini categories. He likes
Impedimed
, which has approval for a device to detect ­lymphedoema, as well as
Acrux
in drug delivery. In the e-health space he is looking at
Azure Healthcare
, which is developing software to help hospitals to be more efficient.

These other categories may be closer to revenue and be less risky, but the flipside is a truly innovative drug will have more upside.

In drugs, Power is awaiting the results of a phase-3 trial from
Alchemia
for its treatment of metastatic colorectal cancer. The results are expected before the end of June.

Chief executive
Thomas Liquard
says if the trial is a success, the drug HA-Irinotecan could hit sales of at least $400 million and up to $1 billion based on a similar product that is used to treat breast cancer. “We’re probably undervalued by half right now," he argues, pointing to US cancer drug developers. Power says the best advice for investors is to dedicate a small part of their portfolio to emerging life science companies “because of the level of risk". He also advocates investors take a “core" and a “trading" position in each company, to weather the volatility. There are plenty of options from which to choose. From the $34 billion plasma and vaccine maker CSL down to the smallest companies, there are about 100 healthcare stocks but about 70 per cent of them have market values less than $50 million, Power says.

Bioscience Managers chief investment officer
Matt McNamara
says investors need to beware of the “zombies" that sit around the $20 million to $30 million mark and listed very early on in their life cycle.

They feed off unsuspecting investors with frequent capital raises that keep them alive, he adds.

Follow the leader

McNamara says one of the best local fund managers investing in the sector is Allan Gray. “They’ve invested in so many and done very well," he says. “If they’re on the register, why wouldn’t you follow them."

For those playing along at home, the fund lead by Simon Marais is a substantial shareholder in stocks like Alchemia (up 59 per cent in the past year), Impedimed (up 50 per cent) and
Nanosonics
(up 77 per cent). But it’s not all rosy. The fund also holds stakes in
Phosphagenics
(down 25 per cent in the same time),
Pharmaxis
(down 72 per cent) and
Starpharma
(down 35 per cent).

The portfolio approach of Marais is one that McNamara strongly advocates. Investors can’t just hope on one or two stocks. They need a portfolio of 10 to 30, he says.

In fact Wilson HTM analyst
Shane Storey
says investors should take their portfolio strategy further with a “technology agnostic" approach to investing in the sector. “I don’t think you can ever know the technology," he says. “I think that if you took an honest look at the risks in biotech you’d very quickly assess that they were infinite."

Storey says one of the best times to hold a stock is after it’s filed its “new drug application" with a regulator like the US Food and Drug Administration, but it can be a good idea to jump out before the outcome is announced. “Coming up to those binary events [the stocks] usually tend to trade up and once you’re really close, then liquidity dries up and you’re trapped and then you find out what end of the trade you are."

Companies in stage-two trials can be of interest, because they’re further from much larger decisions by regulatory authorities and reimbursement authorities, he says.

But most of all, Storey says to keep ­emotions out of investment decisions.

“The problem with these companies is they all make sense," he adds. “They’re all curing diseases. You think ‘I’m helping mankind’ but I’m also losing money . . . Don’t fall in love with them."